2017-10-23

China Topping

For the past 18 months or so, I've said the rally in commodities is the best sign of an inflationary recovery. If prices keep moving higher, it doesn't matter if its real demand or global currency devaluation, it will signal an exit from the post-2008 low growth environment. However, I still believe this is a massive topping process. Xi Jinping's bold 30-year vision looks a lot like a social mood top. Only 5 years ago, one of the big goals was doubling incomes in 10 years. After 5 years of financial bubbles and a brush with a global recession, China's turned even bolder. The shift in vision only makes sense in the context of social mood, the fundamentals argue for a much more humble, circumspect China that needs to clean house before pressing on with a grand strategic vision.

The absolute size and growth of assets imply there will be enormous (as in Biblical) costs to deleverage. Let me give you a simple example. Let’s assume a flat rate of economic financialization by which I mean that nominal GDP and systemic financial asset growth are equal. For our case here, I’m going to use similar but round stylized numbers. In our world, financial system assets are equal to eight times nominal GDP. Now, let’s assume that both financial system assets and nominal GDP grow at 10%. In this stylized but similar world, financial system assets will have grown by an amount equal to 80% of GDP. If this both nominal GDP and financial system assets grow at 10%, by 2025, China will have financial system assets equal to approximately 1,900% of nominal GDP. Because total banking system assets are so much larger than nominal GDP, simply growing both at the same pace will continue to lever up the economy.

This might actually explain one unique data point which no one has a good explanation for, including myself. For a number of year, fixed asset investment in China has been above 80% of GDP. Through the first three quarters of 2017, it is only 3%. It has been puzzling to many how FAI could top 80% of GDP even with the growth in debt that we saw. That was simply an amazing number. Well if there was unseen asset growth of equal to twice official banking system assets, this would explain how FAI could comprise that amount of GDP. However, this implies that China has been much much more dependent on credit and money growth to drive GDP than anyone, myself could have believed.

Speaking on the sidelines of the Communist party congress in Beijing, Zhou Xiaochuan, who is soon to stand down as governor of the PBoC, said: “If we are too optimistic when things go smoothly, tensions build up, which could lead to a sharp correction, what we call a ‘Minsky moment’. That’s what we should particularly defend against.”

This might sound unexceptional. But it is about as close as someone in Mr Zhou’s position can come to yelling “fire” in a crowded theatre. To quote Robert Hockett, an expert on China at Cornell Law School: “It’s calculated to inspire panic. It’s almost an incantation to panic — especially in China.”

Assume the figures Balding cites are true, China's options are rather limited. It can try to shoot the Moon on growth (OBOR), it can devalue the yuan 25 percent (or more), or it can turn into a more crippled version of Japan. While the Japanese have seen their world-beating status wiped away over the past three decades, in real per capita terms, Japanese workers are arguably doing better than those in Europe and the United States. A demographic/debt/welfare state crisis looms everywhere, but the economic standard of living has held steady with the rest of the developed world without using the crutch of mass immigration. It is better if one adjusts for crime and societal decay in the West. This is most evident in the collapse in social trust and fractured politics. Few nations have clear ruling majorities outside of Eastern Europe. In contrast, the Japanese have given the ruling party a majority.

Abe's ruling coalition has won a clear majority with more than two-thirds of Parliament's 465 seats, with the Liberal Democratic Party holding a majority even without its coalition partner, the Komeito party, he told reporters Monday.

"We were able to earn the powerful support of the Japanese people, well surpassing our goal," Abe said at a press conference after Sunday's vote.

China can go the path of Japan. It will remain unified. If the average workers life is improving, the CCP will retain popular support. It might have to put a challenge to the United States on hold for a few decades though.

Xi also laid out an ambitious plan to make China a “great modern socialist country” in the following 30 years — part of what he has called the “Chinese dream.” By 2050, he said, the party would be near the goal of achieving a “beautiful China” with the rule of law, innovative companies, a clean environment, an expanding middle class, adequate public transportation and reduced disparities between urban and rural areas.

“Chinese people will enjoy greater happiness and well-being, and the Chinese nation will stand taller and firmer in the world,” Xi said of his vision for 2050.

...Xi said the Communist Party will strive to fully transform the People’s Liberation Army into one the world’s top militaries by 2050, and emphasized the need to modernize its combat capability.

“A military is built to fight,” he said.

All of this can be accomplished in a "turning Japanese" scenario, but China will turn inwards for 30 years to achieve it.

I still believe the most likely scenario is a controlled yuan devaluation of significant magnitude. A Japan scenario will happen if nothing is done about the present course. I don't think the OBOR is doable given global social mood. Unless the West turns inward and Islam quiets, China won't be able to achieve the multilateral cooperation needed for the OBOR. Finally, a crisis is always possible, but then I expect China would quickly determine the potential losses and weigh that again a surprise detonation of the yuan, and opt for the controlled collapse.